Specialty Bond Funds: Returns, Expenses, Efficient Markets

By Kjetsaa, Richard; Kieff, Maureen | Journal of Business and Accounting, Fall 2014 | Go to article overview

Specialty Bond Funds: Returns, Expenses, Efficient Markets


Kjetsaa, Richard, Kieff, Maureen, Journal of Business and Accounting


ABSTRACT: There is a reduced probability that bond mutual funds can generate economic returns that outpace bond market benchmarks. Given the relatively narrow range of outcomes (compared with equity funds), costs and net returns are inextricably interlinked. Costs are the dominant factor explaining variation in returns. After the deduction of investment management costs, bond fund investors collectively underperform market averages. Expenses are a deadweight loss to investors. Investors should exercise caution before committing investment capital to high-cost bond funds. Since investors are unlikely to foretell the best-performing specialty (sector) bond mutual funds, they should be alert to a signpost that increases the probability of identifying winners-funds that levy below-average financial intermediation expenses.

INTRODUCTION

A bond is a long-term contract under which a borrower agrees to make payments of interest and principal, on predetermined dates, to the owners of the bond. Issuing bonds is a major source of funding for governments and corporations. Bond markets are more opaque and illiquid than equity markets, with many bonds trading infrequently.

Corporate bonds, unlike Treasury bonds, are exposed to default risk. Corporate bonds are senior to stocks in the event of bankruptcy and feature protective covenants in the indenture agreement. In reference to particular companies, bonds are less risky than stocks. Since they are fixed-income securities, bonds do not provide enhanced yields prompted by prosperous corporate performance.

Specialty bond funds focus on specific market sectors, securities, or investment categories. Bank loan funds primarily invest in floating rate bank loans. Emerging market bond funds invest the majority of their assets in developing countries. High yield bond funds seek a high level of current income by concentrating their investments in lower-quality corporate bonds. Multisector bond funds diversify their assets among government, corporate, foreign, and highyield bonds. Ultrashort bond funds reduce interest-rate risk by investing in lowduration, investment-grade debt instruments. World bond funds invest either exclusively in foreign government and corporate debt or in a combination of U.S. and non-U.S. bonds.

Most investors gain exposure to bonds through mutual funds, especially through 401 (k) accounts and other retirement-savings plans. Shareholders own a pro rata share of all of the assets of the fund and are entitled to a pro rata share of the income.

Bonds and mutual funds invested in bonds are the primary financial assets competing with stocks and equity funds. Investors should allocate a portion of their assets to bonds to diversify the ineradicable uncertainty and risk of stocks and counterweight the variability of returns-consistent with their goals, circumstances and preferences,-and produce income that is more stable and predictable than from stocks.

Individual investors-perhaps in conjunction with an advisor- and professional money managers endeavor to design optimal portfolio allocations among various asset classes. Modem portfolio theory commonly performs an essential role in drafting these blueprints of investment plans.

The efficient market hypothesis postulates that the price of a financial asset such as common stock or a bond is identical to its underlying economic value. Investment professionals are persuaded that asset price and intrinsic value (the sum of the present value of a company's future cash flows) differ.

If the efficient market hypothesis is irrefutable then sophisticated portfolio constmction methodologies, such as those designed by mutual fund managers, cannot succeed in delivering market-beating performance since these managers will not consistently discover undervalued securities.

INVESTMENT COSTS

The implication of the efficient market hypothesis is that an efficient stock or bond market will likely induce relatively similar gross returns from investing, causing net returns to be highly dependent on fees and expenses. …

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